Discovering Value in this Under-the-Radar Credit Card Company

Image source: Discover Financial Services
Last year, investors in Discover Financial Services (NYSE: DFS) were richly rewarded. Entering 2016, shares were just a shade over $52 but, after riding the post-election rally, shares ended the year trading for $72.90, a market-thumping 40% gain! As nice as last year's gains were to shareholders, of much more importance is whether Discover will continue to be a good investment going forward.
In its recently reported 2016 fourth-quarter earnings, the company showed growth on both the top and bottom lines. Revenue net of interest expense came in at $2.358 billion, a 7% increase year-over-year, and diluted EPS grew to $1.40, a nearly 23% gain year-over-year. For the entire 2016 fiscal year, diluted EPS was reported at $5.77, a solid 12% increase from the prior fiscal year.

DFS Revenue (Quarterly) data by YCharts
Across-the-board loan growth Perhaps even better than last year's earnings performance was the growth of the company&#0..

Last year, investors in Discover Financial Services (NYSE: DFS) were richly rewarded. Entering 2016, shares were just a shade over $52 but, after riding the post-election rally, shares ended the year trading for $72.90, a market-thumping 40% gain! As nice as last year's gains were to shareholders, of much more importance is whether Discover will continue to be a good investment going forward.

In its recently reported 2016 fourth-quarter earnings, the company showed growth on both the top and bottom lines. Revenue net of interest expense came in at $2.358 billion, a 7% increase year-over-year, and diluted EPS grew to $1.40, a nearly 23% gain year-over-year. For the entire 2016 fiscal year, diluted EPS was reported at $5.77, a solid 12% increase from the prior fiscal year.

Across-the-board loan growth

Perhaps even better than last year's earnings performance was the growth of the company's loan portfolios. Every single loan category experienced at least some growth. In the earnings press release, Discover CEO David Nelms stated:

We are proud of all we accomplished in 2016, including record originations in personal and student loans as well as strong new card account growth, all of which helped us to achieve nearly 7% loan growth. In 2017, we will continue to invest for long-term growth and remain focused on capital return.

The most important of these for Discover, its credit card loan portfolio, ended the quarter at $61.5 billion, a 6% increase year over year. In the quarter's conference call, Nelms attributed this growth to two primary factors. First, the company launched its Credit Scorecard, which provides existing and potential card holders with their FICO score. Second, the Discover it Secured Credit Card was introduced for customers looking to establish or rebuild their credit scores.

Because of the success of these two initiatives, CFO Mark Graf explained, Discover was able to grow its credit card loan portfolio without hurting its strong credit quality. While Graf admitted that new card holders with no or low FICO scores did sign up for the secured card, its risk-adjusted returns were similar to its traditional credit card portfolio because Discover was holding collateral from these customers.

Personal loan originations exploded to $4 billion, a rather incredible 31% gain year over year. CEO Nelms believes several noteworthy product enhancements led to this gain including an improved mobile app, an increase in the available maximum loan amount, and functionality which allowed customers to check their rates and monthly payments without hurting their credit score.

Student loan originations also increased by a significant amount to $1.4 billion, an 18% increase over last year's fourth quarter. Nelms stated increased marketing, a greater field sales force, and a redesigned app all played a role in this growth.

The cost of doing business

Of course, there were costs associated with this growth. Discover's reward costs, counted as "contra revenue" on the balance sheet, rose 10% to $411 million. Management stated its reward programs remain popular with customers, specifically its 5% rotating categories. Nelms explained the 5% rate was both a "very good headline rate" that the company can "aggressively market" and a "very good value" for card holders. He also said the rotating nature of the rewards helps drive customer engagement.

The provisions for loan losses also increased to $578 million, a 19% year-over-year increase. CFO Graf said the increase was due to higher charge-offs and a larger reserve, both driven by "the seasoning of loan growth".

Discovering value

While the higher provisions and rewards' costs are to be watched, neither seems too alarming for investors at current levels. Indeed, Discover maintained a robust 21% return on equity, its fourth straight year of remaining above 20%. Management also raised guidance for loan growth in the year ahead, projecting a new range of 5.5% to 7.5% growth.

Discover enjoyed mighty gains the past year but, because it did so from a starting point of a depressed valuation, there is nothing to suggest it cannot turn in another market-beating performance. While it is doubtful the company can repeat its incredible 2016 performance, there is still much to like. Management remains shareholder friendly, buying back almost $2 billion worth of shares this past fiscal year and raising the dividend by 7% last summer. The price-to-earnings ratio remains reasonable and currently resides at just under 12.

And Discover's customers seem to like the product. Not only is this seen in the company growing every single one of its loan portfolios but, let's not forget, Discover ranked the highest in credit card satisfaction in the J.D. Power ratings last year. That was the third year in a row Discover took home the prize!

Overall loan growth is accelerating too. In the first quarter this year, overall loan growth was 4%. In the third quarter it accelerated to 5%. This quarter it inched up again to 6%. Not only can loan growth drive earnings higher, but could well lead to an increased multiple too.

A product customers like, a sensible valuation, raised guidance, and accelerating business growth? Hmm, long-term investors might want to consider "discovering" this stock for their portfolios.

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